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Ensuring Stability during Surging Inflation

04-16 12:18 Caijing Magazine

Inflation can't be stopped. Taking the right steps to get past it is our challenge.

By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Limited

The price of Thai white rice, a benchmark for international rice trade, surged 30% to $790/ton on March 31st, prompted by news of various countries restricting food exports.  Its price has doubled since the end of 2007 and nearly quadrupled from the level in 2003.  The FAO food price index has roughly doubled in the past two years.  The price trend for food at present bears an eerie resemblance to the oil price at $50/barrel -- the point that oil market began to attract large amounts of speculative capital.  Investment funds that specialize in the futures of agricultural commodities are becoming popular.  Soon, speculative capital may take over the pricing of food products and cause food price to double from the current level.

At the same time, China’s labor market may enter a phase of re-pricing.  Between 1995-2005, the wage for unskilled workers in China barely changed despite the economy rising at 8% per annum.  This is because the excess supply of labor kept the labor market a buyer’s market.  Chinese workers competed against each other and settled for wage at a minimum acceptable level.  Hence, they didn’t share in the upside in an expanding economy.  The low wage has caused global production to relocate to China on a massive scale and has also triggered robust growth of the service sector.  At the same time, the government has engaged in massive infrastructure expansion to absorb surplus labor.  All three developments have rapidly expanded labor demand.  Some sort of turning point has been reached.  The labor market now seems no longer a buyer’s market.  For the first time, wage, especially for youth labor, is now under enormous upward pressure for two reasons.

First, the cost of living has increased enormously.  The consumption basket of unskilled workers or their families has a high share of food products.  The enormous inflation of food products has decreased real wage for such workers.  Hence, the nominal value of the minimum acceptable wage has increased.  Second, the demand for youth labor exceeds supply at the current wage level.  The ’shortage’ of labor in Pearl River Delta, which has gotten worse this year, really reflects that factories are not paying market wage.  The two factors suggest that China’s unskilled labor requires re-pricing so the market can reach equilibrium.  Mean reversion suggests that the wage level needs to reclaim the lost growth relative to GDP since 1995.  I think that wage for unskilled labor in China will likely rise by 50% between 2008-2010.  As labor productivity growth is about 8% per annum and total factor productivity 4% per annum, the re-pricing of labor cannot be absorbed by productivity growth, even if capital’s income share in GDP declines significantly, and will cause significant inflation.

Inflation is a slow moving variable.  When it becomes visible, it is too late to stop it.  The Chinese government has announced an inflation target of 4.8% for 2008.  Its purpose is to contain inflation expectation.  While the intention is good, the government should be careful about losing credibility.  If the population perceives that the government’s effort in fighting inflation is just rhetoric and not action, they may take actions to defend themselves.  In the past episodes of high inflation, Chinese people engaged in hoarding essential goods to fight against the devaluation of paper money.  Such behavior can exacerbate inflationary pressure and cause a vicious spiral.

It is probably too late to stop inflation now.  Indeed, the re-pricing of labor should not be stopped at all.  It is good for social stability that Chinese labor is claiming their share in China’s prosperity.  It also will force businesses to use labor more efficiently.  Ten years ago, I visited an electronics assembly factory.  “They are all eighteen,” said the manager as he pointed at rows and rows of young girls hunching over their worktables.  “In a few years, their fingers will not be so nimble.  We will get a new batch.”  Such callous remarks summarized the attitude of some businesses in treating Chinese labor.  They believed in eternal labor surplus.

When you walk into a high-end restaurant, a line of waiters greet you.  This is purely decorative use of labor.  Such wasteful use of labor reflects low labor cost.  In the West, the daily income of a waiter is 2-4 times of a customer’s meal cost.  In high-end restaurants for business meals in China, it is 0.3-0.5 times.  This is why restaurant owners find it lucrative to use so much labor for decorative purposes to attract business. 

On the other hand, many workers in their forties or even thirties are retired.  When you walk through cities like Chongqing or Chengdu, you see crowds of such retirees playing mahjong on the sidewalks.  When youth labor is plentiful, businesses prefer to hire them, because they are easy to train and can adapt to the rapidly changing environment better.  However, a bit more training can turn the retired middle-aged workers productive.  It is totally irrational for a society to leave such people who are in their prime to idle.

The re-pricing of China’s labor doesn’t mean that China’s labor is no longer cheap.  It is still cheap, just less cheap.  Nor does it mean there is an absolute labor shortage in China.  As youth labor inflates in cost, businesses will make labor use more efficient and find it profitable to train middle-aged workers.  The Chinese economy is wasteful in using resources.  The worst is in wasting labor.  The re-pricing of labor in the coming years will force the economy to become more efficient.  When businesses restructure their labor use, China will not lose as much competitiveness as the rising labor cost suggests.

Surging labor cost cannot be controlled by the Chinese government.  Nor could its food price.  Agriculture has been unprofitable around the world for decades.  Governments in developed economies have provided massive subsidies to farmers to keep them in business.  The introduction of biofuel in response to surging oil price was the catalyst for the surging food price.  The United States introduced subsidies for turning corn into ethanol as a gasoline substitute.  It established a linkage between the prices of agricultural commodities and oil.  As oil price has kept surging on speculative capital, it has lifted the prices of agro commodities.

Instead of playing through oil, speculative capital is now moving into agricultural commodities directly.  The price surge in the past three months has much to do with the setting-up of investment funds that buy futures of agricultural commodities.  What’s occurring in agro commodities now bears striking similarities to the oil market when its price hit $50/barrel.  The momentum is attracting financial capital.  Even though the futures market is not deep, as capital flows in and prices surge, the market becomes larger and more liquid, which attracts more capital.  Big investment banks are beginning to provide research support and trading instruments.  More and more analysts will put sensational price targets on agro commodities like they did on oil.  Like oil before, agricultural commodities may become a big bubble in 2008.
Financial speculation happens when a market has positive momentum.  It is a magnifier of an established trend.  Oil, for example, did have strong demand due to the strong global economy.  The supply response has been muted as governments control over 80% of oil reserves, and they have low incentives to increase supply when they already have enough money.  Financial capital sees the low supply and has kept price surging despite demand weakness.  Hence, the support for the oil bubble has switched from demand strength to supply weakness.

Similarly, the fundamentals for agricultural commodities have been improving for the past five years.  As mentioned above, the linkage to oil has boosted the fortune of the agro commodities.  The food demand for eating has also been improving.  Emerging economies have experienced four years of strong growth.  They tend to spend their income gains on improving diet, i.e., more meat and dairy products in their food consumption.  It means more demand for grain.  Despite a weak US economy, emerging economies will continue to grow at a healthy pace, because they have high reserves of foreign exchange and can continue to invest despite export weakness.  As fundamentals for agro commodities remain strong and speculative capital lacks alternative outlets, capital will flow into this market and exaggerate the increase of food prices.
Energy and food is the twin scourge for global inflation in 2008.  The monetary policy of the Fed is the root cause for all the bubbles in the world.  The Fed is printing money to save the US financial system.  The monetary expansion is causing dollar depreciation and inflation, which makes commodities attractive.  As traditional financial instruments like stock, credit and bond are in bear markets, excess liquidity has been pouring into commodities.  The commodity bubble will burst when the Fed shifts its policy priority to price stability from financial stability.  It doesn’t appear likely in 2008.  The Fed may not even shift its policy in 2009.

It appears that the Chinese government can’t stop inflation from surging in 2008 or even in 2009.  Food prices and wages are increasing.  Does that mean that the government shouldn’t do anything about inflation?  It would be very wrong if one concludes that nothing should be done because inflation cannot be stopped in the short term.  Inflation can cause instability in three ways.  First, the expectation of sustained high inflation can cause businesses to raise prices and workers to demand wage increase.  The spiral could last longer than the necessary price adjustments of food and labor.  The government has to take actions to convince businesses and workers that it will bring down inflation in the future.  The expectation for low inflation in the future will moderate their behavior.

Second, inflation can frighten savers about the value of their bank deposits.  Chinese households have Yuan 18 trillion in bank deposits.  The deposit rate is four percentage points below inflation at present.  Chinese households are losing Yuan 2 billion on the real value of their deposits everyday.  The fear for further loss may inspire savers to withdraw deposits from banks and purchase commodities like cooking oil, rice, or toilet paper for value preservation.  Hoarding happened in every episode of high inflation in China.  Unless something is done, it could happen again and destabilize the country.

There are already many cases of hoarding.  In Taipei, consumers queued to buy toilet papers.  Hong Kong just saw panic-buying of rice.  In China, cooking oil is one favorite for hoarding.   Some shops limit customers to one bottle for each purchase.  Such practice invites people back tomorrow to buy more.  Down this slippery path, China may have to ration essential goods again, setting the country back twenty years in developing a market economy.

Third, people on fixed pay like pensioners, welfare recipients, and students are hit hard by inflation.  India, Yemen, Mexico, Burkina Faso and several other countries have had, or been close to, food riots in the last year, something not seen in decades of low global food commodity prices.  The US government has a food stamp program to ensure social stability for the low income group.  The US’s Congressional Budget Office (CBO) projects that by October, 28 million people will depend upon federal food assistance, up from 26.5 million in 2007. This will be the largest number of people depending on food stamps since the program began in the 1960s.  To maintain social stability during surging food price, a government must help the people on fixed pay.  If China doesn’t take preventive measures, it may see similar disturbances as other countries have seen.

To safeguard stability during inflation, China must protect the value of bank deposits by raising deposit rate above inflation, increase fiscal transfers for the disadvantaged, and avoid price control.  Many are worried about attracting hot money if deposit rate is raised.  This is a legitimate concern.  It can be addressed in two ways.  First, China can tighten up capital account control.  The recent tightening measures are already having an effect.  Underground money shops in Hong Kong now charge up to 10% commission for channeling money into China. 

China can and should tighten capital account control.  While capital account convertibility is desirable in the long term, a higher priority now is to increase monetary independence.  The Fed is pursuing a policy to stabilize its financial system and is tolerating inflation for now.  Without monetary independence, inflation can spike out of control in China.  One big hole to plug is the allowed HK$ 10,000 purchase of Rmb per day in Hong Kong.  The total amount of Rmb deposit in Hong Kong through this channel totaled Rmb 48 billion in February 2008, up from Rmb 30 billion November 2007.  The amount is still small but is rising rapidly.  It may pose a challenge to the stability of the Hong Kong dollar.  As Hong Kong citizens convert their HK dollar into Rmb, the former may vanish.  China may have to close this loophole soon for China’s and Hong Kong’s stability.

To discourage hot money, China can raise long-term deposit rates first.  For example, for two-year deposits or longer, China could introduce inflation plus interest rate, similar to the inflation protection bonds or TIPS in the US.  Hot money rarely has the patience for a two-year bet.  Hence, raising long-term deposit rates will hardly attract more hot money.  It serves the purpose as a safe haven for savers who are worried about the vanishing value of their hard-earned money.

China can issue inflation protection bonds like the US government already does.  The introduction of such an instrument can improve China’s financial stability.  Life insurance companies face enormous risks when interest rates fluctuate.  Because their liabilities are fixed in nominal terms and their income depends on interest rates, they can sink into negative equity value like in 1998.  The inflation protection bonds can stabilize this part of the financial system.  Also, banks can use this market to offer inflation protection deposits, which benefits most households.

China’s fiscal situation is excellent now.  The fiscal revenue bottomed at 11% of GDP in 1990s.  It is now 20%.  Further, state-owned enterprises in telecom and financial sectors are flush with profits and can contribute to fiscal revenue if need be.  The SoEs were in dire financial condition in the 1990s.  The Chinese government now has plenty of money to protect the disadvantaged during inflationary periods.  Steps have already been taken to increase pension payments for retirees and allowances for college students.  If need be, more actions should be taken.

In the Chinese bureaucratic culture, it is always tempting to use price control to deal with inflation.  However, it is very damaging for the economy in the long run and may even cause a crisis.  Price controls are an invitation for panic-buying and hoarding because it under-prices goods.  Rational consumers will buy more under-priced goods, which leads to shortages.  The widespread shortage of diesel fuel, for example, is a good example.  The prices for processed petroleum products are 30% below crude price.  It leads to smuggling of such products into the international market.

China may repeat the mistake in the grain market.  As international prices surge, imports stop, which pushes up local prices.  The government may unload inventories to keep domestic prices low.  This is a high risk move for two reasons.  First, we don’t know the true level of inventory.  China imports over 50 million tons of feed meals per annum.  It is hard to see how long the inventory can last to replace imports.  Second, there could be smuggling of under-priced Chinese grain into surrounding countries in Southeast Asia.

While inflation is picking up, the Chinese economy is also slowing.  Much of the world is experiencing the same.  China, however, is slowing from a high level.  If the growth rate drops by 30% to 8%, it is still a good growth rate.  China didn’t have trouble in the 1990s at a similar growth rate.  However, China always gets into trouble when inflation is a double digit rate.  Hence, China’s policy priority should be inflation rather than growth.

Inflation can’t be stopped now.  But it must be managed to ensure it declines over time and society remains stable in the meantime.  Raising interest rate is the right approach.  Price control is the wrong one.

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